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Risk of Rare Disasters, Euler Equation Errors and the Performance of the C-CAPM

Author

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  • Olaf Posch

    (Aarhus University and CREATES)

  • Andreas Schrimpf

    (Bank for International Settlements and CREATES)

Abstract

This paper shows that the consumption-based asset pricing model (C-CAPM) with low-probability disaster risk rationalizes large pricing errors, i.e. Euler equation errors. This result is remarkable, since Lettau and Ludvigson (2009) show that leading asset pricing models cannot explain sizeable pricing errors in the C-CAPM. We also show (analytically and in a Monte Carlo study) that implausible estimates of risk aversion and time preference are not puzzling in this framework and emerge as a result of rational pricing errors. While this bias essentially removes the pricing error in the traditional endowment economy, a production economy with stochastically changing investment opportunities generates large and persistent empirical pricing errors.

Suggested Citation

  • Olaf Posch & Andreas Schrimpf, 2012. "Risk of Rare Disasters, Euler Equation Errors and the Performance of the C-CAPM," CREATES Research Papers 2012-32, Department of Economics and Business Economics, Aarhus University.
    • Handle: RePEc:aah:create:2012-32
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    References listed on IDEAS

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    Cited by:

    1. Sönksen, Jantje & Grammig, Joachim, 2021. "Empirical asset pricing with multi-period disaster risk: A simulation-based approach," Journal of Econometrics, Elsevier, vol. 222(1), pages 805-832.
    2. Grammig, Joachim & Sönksen, Jantje, 2014. "Consumption-Based Asset Pricing with Rare Disaster Risk: A Simulated Method of Moments Approach," VfS Annual Conference 2014 (Hamburg): Evidence-based Economic Policy 100614, Verein für Socialpolitik / German Economic Association.
    3. Grammig, Joachim & Sönksen, Jantje, 2014. "Consumption-based asset pricing with rare disaster risk," CFS Working Paper Series 480, Center for Financial Studies (CFS).

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    More about this item

    Keywords

    Euler equation errors; Rare disasters; C-CAPM;
    All these keywords.

    JEL classification:

    • E21 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Consumption; Saving; Wealth
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • O41 - Economic Development, Innovation, Technological Change, and Growth - - Economic Growth and Aggregate Productivity - - - One, Two, and Multisector Growth Models

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